Default and Interest Rate Shocks: Renegotiation Matters

Victor Leão Borges de Almeida, Carlos Esquivel, Timothy Kehoe and Juan Pablo Nicolini

No 806, Working Papers from Federal Reserve Bank of Minneapolis

Abstract: We develop a sovereign default model with debt renegotiation in which interest-rate shocks affect default incentives through two mechanisms. The first mechanism, the standard mechanism, depends on how a higher interest rate tightens the government’s budget constraint. The second mechanism, the renegotiation mechanism, depends on how a higher rate increases lenders’ opportunity cost of holding delinquent debt, which makes lenders accept larger haircuts and makes default more attractive for the government. We use the model to study the 1982 Mexican default, which followed a large increase in U.S. interest rates. We argue that our novel renegotiation mechanism is key for reconciling standard sovereign default models with the narrative that U.S. monetary tightening triggered the crisis.

Keywords: Renegotiation; Sovereign default; Interest rate shocks (search for similar items in EconPapers)
JEL-codes: F34 F41 G28 (search for similar items in EconPapers)
Date: 2024-06-17
New Economics Papers: this item is included in nep-dge, nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmwp:98598

DOI: 10.21034/wp.806

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